Should you invest in commercial property as returns on traditional buy-to-let slide?

The woes besetting landlords over the past year have been well documented, with some claiming that the recent reduction of tax relief has wiped out their buy-to-let profits.

Anecdotally, mortgage brokers and lenders suggest investors are increasingly interested in commercial buy-to-let as an alternative to traditional residential lets.

This is because rents on office space and other commercial lets tend to be higher, providing a better yield for landlords when pressure mounts on their costs.

But there are different risks associated with running a property portfolio with commercial tenants - so if you're wondering whether it's a good idea to get into this area as a landlord, here are some things to consider first.

RICS research shows investor demand has risen for UK commercial property across all sectors

What's the difference between buy-to-let and commercial?

Buy-to-let traditionally refers to property let by private landlords to residential tenants - it's rented accommodation for people who need somewhere to live. Mortgage finance assesses the value of the property and rental income in relation to mortgage payments.

Buy-to-let also encompasses what some refer to as 'complex' buy-to-let. This might be anything from a large block of flats with multiple units rented out to different families or houses in multiple occupation (HMOs) which typically house students in separate lockable rooms within a common property. This type of investment usually requires more complicated financing and landlords often invest through a limited company.

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Semi-commercial property is the next step - and usually refers to a building with a shop or restaurant or some other business in one part of the building, with a residential flat in another part of the property.

Commercial property is typically let by private landlords to businesses conducting a commercial enterprise on the premises. Commercial mortgages are assessed on the value of the property, rental income but also, crucially, the business that sits in the property. Its robustness is a factor that affects how likely a landlord is to secure mortgage finance.

The UK commercial property market is a mixed picture

The latest figures from the Royal Institution of Chartered Surveyors suggest that the commercial property market is reasonably healthy, with industrial space outperforming office and retail.

The Q1 2017 RICS UK Commercial Property Market Survey showed that investor demand has risen for UK commercial property across all sectors, with 18 per cent more respondents reporting a pick-up in enquiries.

Overseas investment demand also grew across all sectors in Q1, with buyers again showing a slight preference for industrial space. The industrial sector also performed strongly in terms of capital value expectations with 44 per cent more respondents anticipating prices to rise over the next three months - the highest reading since Q4 2015.

Meanwhile research published by Knight Frank showed that UK commercial property volumes dropped by 35 per cent in 2016 to £46billion, representing the end of three consecutive years of growth.

The property company said this out-turn reflected growing uncertainty surrounding the UK’s decision to exit the European Union and forced some investors to reassess the pricing of acquisition targets.

The report said: 'However, the slowdown in the investment market during the summer months did inadvertently create a catalogue of available assets marketed at “Brexit factored” prices.

'This was pivotal in delivering the strong uplift seen in Q4, which represented the fastest quarter-on-quarter growth in investment volumes for three years. Overseas investors continued to dominate, with £24billion directly invested to UK commercial property in 2016 – accounting for 49 per cent of all investment.'

The devaluation of the pound against other major currencies in the second half of last year following the EU referendum has meant that UK property looks relatively cheap at the moment, propelling demand for assets.

It's important to remember though, that commercial property can mean quite different things. Knight Frank's research is likely to refer mainly to large, expensive office and retail buildings in UK cities. This is type of commercial property invested in by large property funds and investment trusts.

The performance of these funds can be a good indicator of investor confidence in commercial property - and in June last year, the month Britain voted to leave the EU, retail investors withdrew £1.4billion from these property funds - 6 per cent of the sector's £23.3billion assets.

£5.2billion of commercial mortgage business was written in the year ending 30 June 2016

Compare this to the much smaller market for corner shops, takeaways and independent restaurants that typically account for commercial mortgages.

The most up to date figures available from the National Association of Commercial Finance Brokers suggest that £5.2billion of commercial mortgage business was written in the year ending 30 June 2016.

However, demand for this sort of investment is growing strongly - up by 55 per cent on the previous year and the second strongest area of growth for NACFB’s members after short-term bridging finance.

Should you invest in commercial buy-to-let?

Before you decide, it's a good idea to speak to a specialist who will help you understand the commitment and risk you're taking on.

This is not a straightforward way to make money, but for an increasing number of seasoned buy-to-let landlords, commercial opportunities are becoming more popular.

This is not a straightforward way to make money, but commercial opportunities are becoming more popular

Steve Olejnik, of specialist buy-to-let mortgage brokers Mortgages for Business, said: 'Since the Government announced a series of fiscal and regulatory changes to buy-to-let, we have witnessed a growing number of landlords explore commercial property investment.

'Semi-commercial properties in particular, are growing in popularity because they typically produce higher yields than vanilla buy-to-let and are not subject to the stamp duty surcharge or the tougher affordability calculations on personal buy-to-let borrowing.'

Returns tend to be higher on semi-commercial properties

Over the past six years, semi-commercial properties produced an average annual gross yield of 7.6 per cent compared to 6 per cent for vanilla buy-to-let

Semi-commercial properties or mixed use properties as they are also known, consist of both a commercial and residential element - often shops or offices with flats above.

Research from Mortgages for Business shows that, over the past six years, semi-commercial properties produced an average annual gross yield of 7.6 per cent compared to 6 per cent for vanilla buy-to-let.

Buy-to-let mortgages are not available on semi-commercial properties so investors have to go down the commercial finance route. This can be a challenge for residential landlords as the high street banks tend to offer the best rates but insist that the borrower has commercial experience.

High street lenders also prefer the tenant to have a strong covenant (quality) and like the lease length to mirror the term of the mortgage, usually five to 15 years. This applies to both semi-commercial properties and solely commercial buildings.

Getting commercial finance

Steve Olejnik, of specialist buy-to-let mortgage brokers Mortgages for Business

Finance for investors looking to cross over from residential to commercial property is available from specialist lenders - albeit at a slightly higher price.

Olejnik says: 'We regularly work with the likes of Aldermore Bank, InterBay Commercial, Market Harborough Building Society, MetroBank, Norwich & Peterborough and Shawbrook Bank to get these deals across the line.

'These lenders take a different stance to the high street banks, helping investors move across to commercial if they have a few buy-to-lets to back up their experience as landlords.

'The trick is knowing which lender to approach and of course, that’s where the broker comes in. Most of the specialist lenders can only be accessed by brokers who act as a sort of quality control filter.'

InterBay Commercial has a particularly innovative approach. It will offer rates depending on yield - a lower yield means a better rate - because the tenant is more likely to be a well-established business on a longer-term lease and less likely to default.

Also, its debt service cover ratio is currently 125 per cent and that is regardless of whether the investor is borrowing personally or via a limited company. By comparison, nearly all residential buy-to-let mortgages now require this ratio to be 145 per cent.

Olejnik adds: 'We often use Norwich & Peterborough for older borrowers. For example, we recently had a client who was 61 looking for a commercial mortgage. N&P offered him a 14-year term but crucially, on a 25-year repayment profile. When the 14 years are up, the client will either sell-up or refinance depending on the circumstances at the time.'

InterBay and N&P are just two examples but each lender has its own quirks and preferences.

These days, many will offer an interest-only period and consider shorter leases.

Most prefer stable retail and business/trade operations. They are less keen on pub and restaurant investments where the quality of operator and business failures rates are high.

TOP TIPS FOR COMMERCIAL PROPERTY INVESTORS

Moore: Use reason before you take the plunge into commercial market

Rob Moore, of property education provider Progressive Property, warns that commercial property investment is not for the faint-hearted. He shares his top tips below.

While there are always opportunities to be found in the buy-to-let commercial property market, there are also always reasons to be cautious, and red flags to acknowledge.

We are living in an unpredictable financial climate, with Brexit and June’s snap general election clouding the judgments of economists, so now is certainly a good time to exercise caution and recognise the deals and properties that are advisable to avoid.

It is a time to use R.E.A.S.O.N.

R. Run down

We have encountered many new investors who have fallen into the trap of snapping up a commercial property simply because of its too-good-to-resist price tag. Major renovation and improvement work is not only a pain for your wallet but also intensely time-consuming.

Repairs and costs for rundown properties have a habit of spiralling unaccountably, so stick to cosmetic work only if you can.

E. Expensive

If a building costs more than the rent it brings in, then it is a money drain and is not an asset. The basic rule we recommend for a single let is to come under the first level of stamp duty, which currently stands at £125,000. Yields of under 8 per cent gross are likely to cost you money every month, so think hard before you invest.

A. Abroad

Buying properties abroad is a risky strategy. The appealing idea is that, if you buy a property in a desirable location such as the Caribbean or Dubai, you are purchasing both an investment and a holiday home!

Sweet. Sorted. Except, no.

We put deposits down for a couple of properties in Florida, but thankfully got them back before we found ourselves in trouble. The problem is that areas billed as hotspots (i.e. areas of investment that are billed to rise in value very quickly) are often based on rumours that emerge from unreliable sources and local governments announcing a regeneration project. This is speculation and prediction, not provable evidence.

This is not to say that overseas investment can’t work, but expert property investors who purchase properties in foreign lands generally know the language, have property in or are moving to the country, and know the area as well as their home town or city. So we recommend that you save yourself the hassle and keep things simple, for now.

S. Scattergun

Dotting properties around the country is generally a poor idea for reasons that also apply to the previous point: you want to become an expert in your area(s) of investment, and remote management puts you at risk from spreading yourself too thinly and failing to pay enough attention to your properties.

We have seen investors buying low-cost properties across the country, thinking that they have found a set of fantastic deals, only to find themselves in possession of a portfolio only half-occupied. On one occasion, we saw an investor purchase 90 properties scattered across the country and then fold due to the £25,000 it was costing him every month!

So don’t buy all over the place – find your local goldmine area and stick to it.

O. Off plan

Buying off plan – buying the property before it is built, with only the plans available to inspect – is a risky strategy. It is not as lucrative as it was a few years ago when the rising market added value to the property before building commenced, and doing so now is to base your tactics on luck rather than anything tangible.

N. New build

Any new build property is likely to be overpriced because of taxes, new premiums and developers’ margins. It's just like buying a brand new car straight out of the show room: its value is going to drop the moment the vehicle rolls off the forecourt or the property is purchased.

While it was once the case that if you bought a property at the start of its development, the rising prices would drag the value up by the second or third phase. Not so, anymore, which means that as a general rule, buying new builds fails to provide any certainty of a lucrative deal anymore.

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